By John Hughman & Graeme Davies , 19 December 2014
Banks spent much of the year trying to restore their thoroughly tarnished reputations by cleaning up their operations, but there was no escape from past misdemeanours in 2014. Indeed, while consumer price inflation melted away, so-called bank “fine inflation” – as it was described by star fund manager Neil Woodford – continued to ratchet up. By far and away the largest fines meted out were for “failing to control business practices” in their forex trading businesses – or more specifically, it seems, betting against their clients for five years. The £1.1bn aggregate fine across five banks was the largest ever levied by the Financial Conduct Authority. Add in the fines simultaneously imposed by US authorities and the figure climbs further still, to a massive £2.7bn. Mr Woodford has publicly presented rising fines as a reason he sold his entire holding in HSBC in August – and it seems likely that, with fines now arguably seen as an additional way in which to tax the excess profits banks are held to have made in the past, 2015 could see further inflation.
At the start of 2014 there were widespread predictions that the fixed-income bubble was set to burst as QE was pared back in the US and, to a lesser extent, the UK, and that investors should dump their bond fund holdings in anticipation of interest rate rises. Instead, investors seeking a safe haven continued to pile into gilts and their overseas equivalents, causing yields to plumb record lows. The trajectory of German government bonds has been particularly noteworthy, with the average price of a 10-year Bund climbing 400 basis points since September to a level that leaves them yielding significantly less than 1 per cent. That was a level breached for the first time this summer, and represents several convergent beliefs: that the outlook for eurozone growth is still extremely weak; that as a result the European Central Bank will need full-scale quantitative easing to fend off deflation; and that German Bunds, the largest and safest port in the European storm, will be purchased in huge volumes by the ECB. Which could mean that fears that the g-bond bubble will burst this year instead could again be misplaced.
Volatility as measured by the Vix index continued to trend lower in 2014, bar one or two unseemly spikes – the latest of which we are bang in the middle of as we go to press, the apparent consequence of the plunging oil price. Popularly observed as a gauge of market sentiment, the Vix – a measure of the implied volatility of S&P options – is often referred to as the fear index. When investors are less fearful, they buy equities or other similarly risky assets, which explains in very simple terms why the volatility index displays a visibly inverse correlation with the S&P 500 equity index itself. This characteristic has led several observers to suggest that the Vix itself has no predictive power whatsoever – and hence, by extension, that we should not be especially concerned that the relatively small spikes we saw in 2014 are in themselves a harbinger of bad times ahead.
The boom in production of shale oil in the US has seen the country’s oil output over the past couple of years return to levels last seen when JR Ewing was gracing our television screens in Dallas in the late 1980s. But as the year draws to a close there is a genuine threat to the US re-emergence as a global oil producer. Although improved technology and new drilling techniques have reduced the break-even cost of most shale oil in the US to around the $80 a barrel mark, the 45 per cent slump in the price of Brent Crude on global markets over the second half of 2014 threatens to choke off new projects and could see existing production mothballed if the oil price slump is prolonged. It is arguable that the Opec countries are willing to absorb the lower oil price if it forces uneconomic producers out of the game, but for the US, which has seen its industry revived by access to lower-cost home-grown sources of energy, it remains to be seen whether it can maintain the revival in its oil output in such a pricing environment. The future success of the US industry could also have a bearing on how quickly, and economically, other regions such as Europe and UK are able to exploit their shale reserves.
UK companies spent the first half of 2014 bemoaning the strength of the pound as sterling appreciated along with growing expectation of interest rate rises. But over the second half of the year the situation reversed itself as the dollar started to build up a head of steam against sterling, and most other currencies, that has led to predictions of a multi-year bull run for the greenback. Indeed, the prospect of interest rate rises in the UK has now receded into the distance; most economists now expect no move upwards until the second half of 2015, and the US is thought likely to hike rates in the opening six months of next year, which should further cement the strength of the dollar. Quantitative easing in Japan and the likelihood of more monetary easing in the eurozone have enfeebled both the yen and the euro and the economic woes being heaped upon Russia by a combination of the weakening oil price and economic sanctions have sent the rouble into a tailspin from which it is difficult to envisage a recovery for some considerable time.
Far from being a nation of shopkeepers any more, it appears as though Britain is becoming a nation of landlords. As the chart shows, the popularity of buy-to-let didn’t die in the financial crisis as owner-occupier numbers continue to fall and renters rise. Indeed, it is now becoming apparent that the recent strength in the housing market may have been driven more by landlords than any government incentive to try to help first-time buyers get on to the first rung on the property ladder. There are now believed to be more than 2m buy-to-let landlords in the UK and their insatiable appetite for property means landlords now own around one-fifth of all the private housing stock in the country, having seen their property holdings double over the past decade. The trend has been exacerbated by baby boomers looking for alternative homes for their savings in the wake of the banking crisis and the prolonged period of cheap credit as interest rates have been kept at record lows for more than five years now. The longer-term impact on a housing market where first-time buyers continue to struggle to find property and new-build levels remain below that needed to house the growing population remains to be seen, but the buy-to-let phenomenon has enjoyed one of its most buoyant years yet in 2014.
For equity investors the US was the place to be in 2014. Shrugging off concerns over global growth or the removal of quantitative easing, the country’s benchmark indices powered ahead, led by the Nasdaq 100’s near-16 per cent gain, with respective 7.6 and 3.6 per cent rises from the broader-based S&P 500 and Dow Jones Industrial Averages. It proved a stark contrast to the FTSE 100, down 7.5 per cent in the year to date, a double-digit underperformance against even the worst performing US benchmark. The simple explanation for this divergence is natural resources: the FTSE counts several miners and integrated oil producers among its largest constituents, all of which suffered as commodity prices plunged to long-term lows throughout the year. The FTSE’s reputation as an international index also hurt: currency weakness hit the profits of large consumer goods groups with significant emerging market exposure, a problem not faced by more parochial US counterparts. Indeed, more than two-thirds of FTSE 100 turnover is generated outside of the UK; conversely, for the S&P 500, two-thirds of sales are domestic.
After spending much of the opening decade of the century doing their utmost to be seen to be keeping the inflation genie in the bottle, central bankers in many parts of the world are now suddenly faced with the opposite prospect. Indeed, in the eurozone in particular, there is a real risk of deflation getting its icy claws into the economy. Despite ultra-loose monetary policy, normally a recipe for stoking inflation, even the recovering economies and the US and UK are showing no signs of inflationary pressure. Indeed the latest forecasts for the UK show inflation unlikely to even threaten the Bank of England’s 2 per cent target rate before the end of 2016 or well into 2017, and in the US inflation expectations remain subdued too, with the recent slump in the oil price is likely to further exacerbate this situation. But all this could change if and when economic recovery feeds into higher wages, and in the UK we may finally see sustained real terms wage growth for the first time in years in 2015 while US wages are also forecast to pick up pace during the next 12 months. But, for now, inflation – which many a central banker would privately admit to wanting to see more of in order to inflate away the hefty debts which continue to choke the global economy – is well and truly dormant.